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Research Highlights 2010: Finance and Private Sector Development

The Finance and Private Sector Development group focuses on understanding the role of the financial and private sectors in promoting economic development and reducing poverty, and identifying policies to improve their effectiveness. Finance research is organized around access to financial services and risk management and stability. Private sector research focuses on determinants of firm entry and performance to better understand the microeconomics of the growth process.

Themes

The research on access to finance—which is important in promoting growth and alleviating poverty—includes documenting and benchmarking access to financial services by small firms and poor households, and identifying underserved groups and analyzing barriers to building more inclusive financial systems. In 2010, the Bill and Melinda Gates Foundation gave a grant to the Development Research Group to construct a new public database on “Global Financial Inclusion Indicators,” to help us achieve this goal. Our evaluative research is studying the channels through which access to finance can contribute to growth through promoting entrepreneurship, innovation, and the process of technology adoption.

Research on the private sector focuses on firm dynamics—changes in the composition of the private sector and entry and exit over time—and performance, and how this affects firm productivity and growth. Special areas of focus include research on the determinants and consequences of informality, innovation, and governance as well as the impact of the business environment and its reforms.

The 2008 financial crisis, which rocked conventional thinking in areas of finance and private sector development, continues to reveal key knowledge gaps for new research. First, how do we ensure that financial systems are growth-promoting and inclusive, yet stable? What are the key trade-offs? What roles do financial liberalization, regulation and supervision, and financial education play in this process? Second, are there optimal financial structures at different stages of the development process? What does this imply for the role of banking versus market development, banking structure and size distribution? And finally, which policy interventions enhance the role of the private sector in promoting development?

Highlights

Role of financial literacy in raising demand for formal financial services in emerging markets

Financial literacy campaigns are increasingly heralded as the best way to increase demand for formal financial services in emerging markets. But do they work and for whom? One view argues that limited financial literacy stifles demand. A second view argues that demand is rationally low, because formal financial services are expensive and of relatively low value to the poor.

Original surveys and a field experiment in India and Indonesia show that financial literacy is a powerful predictor of demand for financial services. The relative importance of literacy and price was tested in a field experiment that offered randomly selected unbanked households financial literacy education crossed with a small incentive (US $3-$14) to open a bank savings account. The financial literacy program had no effect on the likelihood of opening a bank savings account in the full sample, but showed modest effects for uneducated and financially illiterate households. In contrast, small subsidy payments had a large effect on the likelihood of opening a savings account. These payments proved to be more than two times more cost-effective than the financial literacy training.[1]

What explains firm innovation in developing countries?

While existing finance literature on innovation is limited to large publicly listed firms in developed markets such as the United States, research using enterprise surveys makes it possible to investigate publicly listed as well as private firms, including small and medium enterprises.

Researchers investigated which firm characteristics are associated with innovation using data for over 19,000 firms across 47 developing economies and defining innovation broadly to include introduction of new products and technologies, knowledge transfers, and new production processes. The results indicate that access to external financing is associated with greater firm innovation. Further, having highly educated managers, ownership by families, individuals or managers, and exposure to foreign competition is associated with greater firm innovation.[2]

Workers’ remittances can broaden and deepen the banking sector in receiving countries

A study of household remittances in Mexico shows that they lead to sizeable increases in the number of branches and accounts per capita and the amount of deposits to GDP. For example, a one standard deviation change in the percentage of households receiving remittances—roughly a doubling of the mean remittance rate—leads to an increase of one branch per 100,000 inhabitants (against a mean of 1.79), 31 accounts per 1,000 residents (relative to mean of 42 accounts), and an increase of 3.4 percentage points in the deposit/GDP ratio (compared to a mean of 4.2).

These effects are significant both statistically and economically, and are robust to the potential endogeneity of remittances, inclusion of a wide range of controls, and even municipal fixed effects specifications using an alternative sample of municipalities. These findings add another channel through which remittances can affect the development of recipient economies.[3]

New business registration dropped in countries affected by the financial crisis

Survey data on new firm registrations was used to explore the relationship between the regulatory environment, institutional quality, and entrepreneurship for 95 countries, as well as the impact of the 2008-2009 global financial crisis. The findings suggest that formal business registration occurs at a faster rate in countries with good governance, a strong legal and regulatory environment, low corporate taxes, and less red tape.

For example, the pace of new registration was the fastest where the cost and number of procedures of starting a business was the lowest. New firm registrations dropped sharply first in developed countries and then in the rest of the world as the financial crisis spread. While nearly all countries experienced a drop in business entry during the crisis, it was more pronounced in countries with higher levels of financial development, most likely because of the credit crunch that has characterized this crisis and the contraction in formal start-up capital. The drop in new business registration was less pronounced in lower-income countries, which tend to have lower rates of new business creation to begin with and where economic shocks bring smaller changes.[4]

What lessons can the recent financial crisis teach us on bank capital regulation?

Existing capital regulation, in its design or implementation, was clearly inadequate to prevent a panic in the financial sector. This investigation looks at whether better-capitalized banks experienced a smaller decline in their stock market value during the financial crisis to inform regulatory reform. What type of capital will ensure that banks can better withstand economic and financial stress? And should a simple leverage ratio be introduced to reduce regulatory arbitrage and improve transparency? Several types of capital ratios are explored: the Basel risk-adjusted ratio, the leverage ratio, the Tier I and Tier II ratios, and the common equity ratio.

Before the crisis, differences in capital did not affect subsequent stock returns. During the crisis, higher capital resulted in better stock performance, mostly for larger banks and less well-capitalized banks, suggesting that calls to strengthen capital requirements is broadly appropriate. The relationship between stock returns and capital is stronger when capital is measured by the leverage ratio rather than the risk-adjusted capital ratio, indicating how difficult it is to properly measure risk exposure for large and complex financial organizations. Finally, higher quality forms of capital, such as Tier 1 capital and tangible common equity are likely to provide more effective protection.[5]

Cole, Shawn, Thomas Sampson, and Bilal Zia. Forthcoming. “Money or Knowledge? What Drives Demand for Financial Services in Emerging Markets?” Journal of Finance. (Based on Harvard Business School Working Paper, 2009)